6 April 2017

Must investing in emerging markets be volatile?

Volatile equity performance in emerging markets has led some investors to chase performance historically, buying shares when prices are high and selling them when prices are lower. Consider the pattern of net flows into an emerging market Exchange-Traded Fund [ETF] as shown in graph 1.

Graph 1: iShares MSCI Emerging Markets Index ETF net flow vs MSCI EM Index return
iShares MSCI Emerging Markets Index ETF net flow vs MSCI EM Index return

Source: Bloomberg, ETF.com. Index returns show Calendar Year performance including dividends and are reported in Australian dollars; Net Flow in US dollars.
Past performance is no guarantee of future results.

For example, after both the U.K.’s Brexit vote in late June 2016 and Trump’s surprise presidential election victory in November, some commentators suggested selling emerging market stocks. However, actual performance shows their advice was not in investors’ best interests. Index performance since the end of June 2016 (in Australian dollar terms) shows the MSCI Emerging Markets Index gained 10.0% contrasted with an 8.4% return for the MSCI World ex-Australia Index, a gauge of developed market equity performance.

Wells Fargo Asset Management (‘Wells Fargo’) the manager of Zurich’s Emerging Markets Equity Fund, believes that there are better ways to invest in the asset class than chasing performance to the detriment of long-term returns. Through their research on emerging markets equities, they found that:

  • Compared with developed markets, emerging markets economies have offered better growth prospects and emerging markets equities typically trade at significantly lower valuations to peers.
  • Investors could be better served by emerging markets investments with a dividend-yield focus, which historically has driven higher returns with lower volatility.

Graph 2: GDP growth for emerging markets vs advanced economiesGDP growth for emerging markets vs advanced economies

Source: International Monetary Fund, World Economic Outlook Database, October 2016
Past performance is no guarantee of future results.

According to International Monetary Fund (IMF) forecasts, gross domestic product (GDP) in emerging markets is expected to grow at an average of around 5% over the next five years. While a 5% GDP growth rate may not seem exciting when compared to the segment’s growth rates in prior years, it is still more than twice the expected GDP growth rate for developed markets, which the IMF forecasts to be approximately 2% over the next five years.

Not only do emerging markets economies appear to offer better growth prospects, but emerging markets equities also currently trade at valuations that are significantly lower than those of their developed market peers. In Wells Fargo’s view, the combination of stronger growth profiles and more compelling valuations make emerging markets equities an attractive asset class. Using the above mentioned MSCI Emerging Markets Index as a proxy, emerging markets equities currently trade at a price-to-forward earnings multiple of 12.5x, compared with a multiple of over 17x for the Developed Markets Index.

Graph 3: Price-to-forward earnings multiples for emerging markets vs developed markets
Price-to-forward earnings multiples for emerging markets vs developed markets

Source: Bloomberg. To end 28th February 2017
Past performance is no guarantee of future results.

In addition to better growth prospects and lower valuations, emerging markets equities typically demonstrate low correlation to both the MSCI Developed Markets Index and the S&P/ASX 300 Accumulation Index. When paired with a traditional domestic equity portfolio, such as the S&P/ASX 300 Index, lower correlation can provide investors greater diversification benefits. There are also diversification benefits apparent when considering emerging markets with developed markets.

Graph 4: 36-month rolling correlation with MSCI Emerging Markets Index
36-month rolling correlation with MSCI Emerging Markets Index

Source: Bloomberg. Returns include dividends and are reported in Australian dollars to end February 2017.
Past performance is no guarantee of future results.

Frequent volatility often leads to performance chasing in emerging markets

Historically, emerging markets equity performance has been volatile, especially over the short term. The MSCI Emerging Markets Index declined 4% in 2015 (in Australian dollar terms) after having advanced 18% early in that year. The index then lost 7% in the first three weeks of 2016, only to subsequently rally 21% and finish the year with a 12% gain. Swings like these may cause investors to chase performance (as shown in graph 1).

Dividends can offer a performance advantage over a market cycle

Within emerging markets, Wells Fargo believes that companies that pay attractive dividends can offer the growth potential of emerging markets, but with lower levels of volatility through a market cycle. Wells Fargo believes that dividend yield can be a leading indicator for good companies with attractive attributes, including strong business models, attractive growth prospects, sustainable cash flow generation, strong financial profiles and minority shareholder friendly management.

As shown in graph 5, the MSCI Emerging Markets High Dividend Yield Index has posted enduring outperformance over the parent index, over the past 9 years. An actively managed emerging market strategy that uses a high dividend yield filter as one of its key inputs, but which can also add value through stock selection and macro-economic decisions, as demonstrated by the Wells Fargo Emerging Market strategy, has produced even more compelling results (also on graph 5).

Graph 5: Growth of $100 invested in different emerging market strategies
Growth of $100 invested in different emerging market strategies

Source: Bloomberg, Wells Capital Management. Returns include dividends and are reported in US dollars to end February 2017. Wells Fargo EM strategy invests in emerging market stocks that pay higher than average sustainable dividends and offer the potential for capital appreciation. The strategy is the parent of Zurich’s Emerging Markets Equity Fund; the chart reflects actual performance (net of fees). MSCI EM High Dividend Yield Index includes stocks from the MSCI EM Index and is designed to reflect the performance of stocks with higher dividend income and quality characteristics.
Past performance is no guarantee of future results.

In addition to higher returns, the EM High Dividend Yield index and Wells Fargo EM strategy also achieved these results with lower levels of volatility, which translated into better risk-adjusted performance and smoother return patterns overall for investors.

For the high dividend yield stocks, an important contribution was the style’s focus on dividend income, which is considered a relatively more stable component of total return when compared to stock price appreciation. Since 2000, dividend income has contributed approximately 40% to total emerging market returns.

Short-term volatility is likely to continue to be a factor in emerging and developed equity market performance. Wells Fargo research shows that investors could be better served during volatile periods and over the long-term through emerging market investments with a dividend yield focus, which can drive higher returns with lower volatility, based on historical performance.

Zurich Investments are proud to have Wells Fargo Asset Management as our strategic investment partner for the Zurich Emerging Markets Equity Fund. Find out more about Zurich’s Emerging Markets Equity Fund here, or contact your Zurich representative to discuss how we can help you.

With reference to: ‘Must investing in emerging markets be volatile?’ by Jo Lee, CFA, FRM from Wells Fargo Asset Management (dated 17th January 2017)

Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated 30th March 2017, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such. Neither Zurich Australia Limited ABN 92 000 010 195 AFSL 232510, nor Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 5 Blue Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich.
Past performance is not reliable indicator of future performance. GINN FVHHKJ.00012.ME.036.
CSTT – 012224-2017

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